Emerging markets: Cheap but risky investment

Jan. 2, 2014
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epa03982437 Supporters of the Indian Bharatiya Janata Party (BJP) spray color dust as they celebrate outside their party headquarter after the announcement of the results of the Assembly elections, in New Delhi, 08 December 2013. / STRINGER EPA

by John Waggoner, USA TODAY

by John Waggoner, USA TODAY

You should always leave the New Year's party before you start an argument with a ficus, and it's certainly best to leave before you lose the fight. Similarly, it's best to come to some investments early and leave them early, which brings us to emerging markets funds.

Emerging markets funds had a lousy 2013, but they started to heat up in the last quarter. Furthermore, they're reasonably cheap, something you can't really say about the U.S. market anymore. And, much like a party, they're much more fun as more people join in. You simply have to be willing to leave early, or be willing to be stuck with a mess when the party ends.

Emerging markets are Wall Street's name for the stock markets in countries that are not among the leading industrialized nations, such as the U.S., Japan and most of Western Europe. We're talking about such countries as Poland in Europe, Thailand in Asia and Brazil in Latin America.

The average emerging markets fund fell 0.1% last year, which is not bad by emerging markets standards. In fact, it's terrific. The worst 12-month fall in emerging markets was a bone-grinding 58% loss in the 12 months ended February 2009, which eclipsed the funds' 45% loss during the 1998 Asian currency crisis.

Nevertheless, if you bet heavily on emerging markets last year, you probably feel fairly silly, given that the average diversified U.S. stock fund gained 34%, and the average large-company international fund gained 19.6%.

Why consider emerging markets now? For one thing, they're relatively cheap, compared with their past 12 months' earnings. The traditional measure of value is the price-to-earnings ratio: Lower is cheaper. The MSCI Emerging Markets Index sells for about 11.6 times its past 12 months' earnings, according to Bloomberg. The Standard & Poor's 500 stock index sells for about 19 times its 2013 earnings.

While emerging markets aren't at their cheapest ever - that was in 1998 - they're still pretty darn cheap. So that's the first part of the argument for emerging markets: They're cheap.

If you've ever stayed in a $39 hotel room, you know that "cheap" isn't the same as "a bargain," particularly if you have to hire a guy named Cronk to stand guard outside the door. When you're looking for stock bargains, you need to get a low price combined with decent earnings potential.

And this is where things get a bit murky, because emerging markets cover a great deal of ground. Last year, for example, the top-performing emerging markets were:

â?¢ Greece (yes, Greece), up 46%.

â?¢ Taiwan, up 6.6%.

â?¢ Egypt, up 6.2%.

All three countries were recovering from epic drops. Beyond them, the emerging markets were pretty much filled with bitterness and disappointment, especially the BRIC countries - Brazil, Russia, India and China - which were hyped in 2009 and 2010. Brazil plunged 18.7%. Russia fell 1.6%. India slid 6.1%. China lost 10.4%.

The great argument for growth in the emerging markets is the emerging consumer class there. People like good food, utilities and conveniences, and the emerging markets have seen a growing appetite for all three. Continued prosperity in the emerging markets could be a bonanza for the companies that sell there.

But growth is likely to be uneven across the emerging markets spectrum, says Stephen Wood, chief market strategist at Russell Investments. China, for example, should see 7.5% GDP growth - a rate that would be insanely fast for the U.S., but is sluggish by Chinese standards. That means that demand for commodities such as iron, steel and wood could be sluggish, as well. For emerging markets such as Brazil and Russia, that's bad news.

Further complicating matters is the Federal Reserve's decision to taper its massive bond purchases, which have kept U.S. interest rates artificially low. Higher U.S. rates mean that investors can get higher, safe returns and might not feel as inclined to send their money to more volatile emerging markets.

Cash flows to emerging markets make an enormous difference. Because some emerging markets are so small, a big blast of money into them is like filling a soda can with a fire hose. In 2012, for example, investors poured a net $43 billion into emerging markets funds, which rose 18% that year. Flows last year were about $27 billion. Should investors feel that there are better opportunities in the U.S., inflows to emerging markets could fall further.

If you believe in buying stocks cheaply, however, it's hard to overlook emerging markets. You might consider three ways to play emerging markets:

â?¢ Via a value fund. Value managers look for stocks that are cheap, relative to earnings. One consideration: Schwab Fundamental Emerging Markets Index (ticker: SFENX), which also charges just 0.5% in annual expenses.

â?¢ Via a broad-based index fund. Vanguard Emerging Markets index (VEIEX) will give you broad exposure to emerging markets, and for just 0.33% a year in expenses.

If you do invest in emerging markets, keep them to a relatively small percentage of your portfolio - say, 10% or less. Why so little? Because many U.S. companies get a big share of earnings from emerging markets, so you have exposure there. And many international funds have a chunk of assets in emerging markets, too. Emerging markets are attractive, but you don't want a hangover.